June 11, 2011

Bitcoin and tulip bulbs

Many people are asking me about BitCoin, and I've put off writing about it because I need to be clear on why I think it is not a long term player. Of course, I've been wrong before ... Anyway, it looks like John Levine has done the job for me:

Bitcoin, for anyone who's not up on their techno-trends, is this year's hot trendy digital payment system. Its main claim to fame is that it is peer-to-peer, not depending on a central bank to issue or validate the "coins", actually blobs of cryptographically signed bits. This makes it both fairly anonymous and hard to manipulate (at least in the ways that real money is manipulated), making it a darling of anarcho-libertarians.

A lot of people have opined on its merits, most notably this Quora message.

I took a look at the design of Bitcoin, which is credited to "Satoshi Nakamoto". Nobody seems to know who he is (or who they are), but he definitely knows his crypto. As a piece of cryptographic software design, it's quite clever. As a system you might want to use to pay for stuff, it's hopeless.

To somewhat adapt the arguments in the Quora message, Bitcoins suffer from two problems, one technical and the other economic. [techo-issue elided]

The other problem is economic. A year ago, you could buy bitcoins for about 1¢ apiece. In January, they cost about $1. Now they're about $10. We have a name for that -- it's a bubble. (Bitcoin fans tend to assume that bitcoins are money, and describe what's happending as deflation, but you'll have to look pretty hard to find any real-world examples of 1000 to 1 deflation.) Since there's no central bank to manage exchange rates, nor can you pay your taxes with them, which is the practical definition of money, a bitcoin is only worth what the next sucker thinks it's worth. So what we have here is a system that lets you pay for stuff with tulip bulbs, or perhaps shares of stock in theglobe.com.

John's rant mostly covers it, but for the hardcore monetarists I'll add: money is expected to be a store of value. BitCoin doesn't speak to value at all, and it is the antithesis of the Ricardian Contract, which describes its value in glorious and legal detail. So it's whatever value we as holders want it to be.

Typically such a bubble bursts when we run out of speculators who agree on its appeal. In this case, it is eerily familiar with history of last decade. It shares something of the media hype of DigiCash, and also the user-base of e-gold. So it will burst when we run out of cypherpunks, and when the user base reaches a tipping point.

And, as Lynn Bell pointed out, last decade was the decade of the alternative issuers. This decade, facebook, apple and google will try it, and may succeed (if that is they can keep the geeks at a distance and build an integrated team with some monetarists in it)...

The biggest drive towards the use of Bitcoins on sites like Silk Road is that they supposedly cannot be traced [1]. However, a member of the Bitcoin core development team told Gawker that "...because all Bitcoin transactions are recorded in a public log, though the identities of all the parties are anonymous, law enforcement could use sophisticated network analysis techniques to parse the transaction flow and track down individual Bitcoin users." ....

What is most extraordinary about the current BitCoin thing -- and what tends to confirm "bubble" to me -- is that the same people who were desperate for the privacy promise of blinded bearer coins are projecting their old privacy beliefs on the nymous BitCoin.

Such a comparison between nymous and untraceable systems was denied vociferously in good old bearer days. Blinded transactions were the only way to do it, and the nymous architecture (as now seen in BitCoin) was considered evil because the issuer could supposedly see "all".

Which tends to confirm to me at least that a lot of support for schemes like BitCoin and DigiCash is based on shared beliefs, memes and is vulnerable to bubbles.

On the other hand, a publically shared database of transactions is one element of Todd Boyle's vision of triple entry.

Payment systems need some rules, governance and monitoring of the amount of value in circulation. Fixing the amount of money in circulation while not having a 'central bank' creats the equivalent of a ponzi scheme.

Furthermore any solid payment system needs a solid legal underpinning of what to do in case of incidents, fraud, disputes which isn't covered properly here. It's what governments usually take care of.

It would be most interesting if journalists would forget about the use of the system IRL but start tracing the flow of money here. Who's behind this, where does the money come from or go to...?

The exchange value for bitcoin will not entirely depend on cypherpunks. One has to equate bitcoin value to the portion of the global economy that values a potentially tax-free, de-politicized, pseudonymous method of commerce. When looked at in this light, it becomes clear that the potential market for bitcoin is the entire ever-growing cash-based economy around the world.

Payment systems need some rules, governance and monitoring of the amount of value in circulation. Fixing the amount of money in circulation while not having a 'central bank' creats the equivalent of a ponzi scheme.--

This is false.

Payment systems do not need rules, (euphemism for legislation), they need stable characteristics only. Gold coins are money, and when their key characteristic, i.e. the weight in pure gold is not changed, they constitute good money.

Payment systems also do not need monitoring; they require trust. The trust in the Bitcoin system comes from the open nature of the transaction records and the block chain / cryptography.

Others have soundly refuted the 'its a Ponzi Pcheme' attack, so I wont repeat that work here, but suffice to say, whoever uses the phrase 'Ponzi Pcheme' in relation to Bitcoin doesn't know what a Ponzi Scheme is, or how it works, and they do not know how Bitcoin works.

--Furthermore any solid payment system needs a solid legal underpinning of what to do in case of incidents, fraud, disputes which isn't covered properly here. It's what governments usually take care of.--

This is absolutely false.

A payment system that is widely trusted and that has stable characteristics does not need the State or its laws to 'underpin it' you clearly do not understand what money is, or how it works. This is nothing more than old wive's tales and nonsense, and the history of money proves that this is so. There are already enough laws on fraud to cover monetary transactions, no matter what the currency is, and in any case, user feedback systems push out fraudsters and reward good honest traders; we have seen this employed spectacularly in Amazon Mercnahts and eBay, both of which prove that the state is not needed to control or reduce fraud.

--It would be most interesting if journalists would forget about the use of the system IRL but start tracing the flow of money here. Who's behind this, where does the money come from or go to...?--

There is a fundamental lack of understanding here of both the true nature of money and Bitcoin. You really must download the software and read the documentation thoroughly to get a feel and grasp of what its all about. As for the matter of what money is, I suggest you read 'What has government done to our money' by Murray Rothbard.

Bitcoin is a bundle of things that are independently quite interesting and of value, but as a bundle they don't work. If the central proposition is to be anonymity, then they are doomed, since the public don't want anonymity.

I am not certain if I agree with your absolute dismission of rules, control, monitoring etc.

Your response reminds me of a Frank Zappa record in which during an intermission at one of his concerts, a man in the public shouts on the top of his lungs to complain about all the policed uniforms and security in the concert hall. Zappa then replies: 'Don't kid yourself: everybody in this room is wearing a uniform'.

Whether we like it or not, there are always rules, power bases, enforcement mechanisms, policing, social control and so on. And the only question is whether in coherence they contribute/lead to a certain goal/consequence or not. And that's where we appear to disagree. While I am pointing at the voids in the institutional design (which is there by definition, however informal it may be), your position appears to be that there is no need for an institutional framework at all.

This is not to say that I am a supporter of Knapps institutional theory of money (if the state proclaims a currency than that's what makes money tick). I'm not. It's not the government that can proclaim a currency. It's always the public.

Yet, as Frijda outlines in his theory of money (1914), the acceptance of the public is based on the knowledge that they are all treated equally, fairly, the currency holds its value and that thieves will be caught (which implies that they are in a state with a good legal system and stable monetary conditions). If these conditions are not satisfied, the currency will only be used by niches of risk-takers or unawares, but will not be used more broadly.

Simon, Frijda's theory of money, (from your description, which describes a woefully flawed theory of money), Bitcoin is in fact a good money.

All the public who use it know absolutely that they are 'treated' fairly, the currency will hold its value (which actually refers to the fact that it cannot be inflated by the State, or by any arbitrary body and not the fact that it fluctuates against other currencies), and thieves cannot steal it from the system.

I am predicting as the hubbub about Bitcoin dies down and people begin to understand how it works by running the client and the more user friendly clients that are sure to follow, all the predictions of the 'economists' that 'it can never work' will be disproven in a most spectacular fashion.

Simon. The goal of any discussion is to find out which assumptions cause the disagreement over which the discussion started. So in essence, discovering our "beliefs" (though I'd like to call them assumptions) is the core purpose of discussion.

Reading this blog post, I am glad the last comment was this:

"Are you willing to let history do the talking and to agree with my point of view if in 20 years time there is no more bitcoin around?"
Allow me to adopt Bruce's stance in this argument and say, yes, that sounds like a fair trial. Though I would like to specify that I'm not sure that Bitcoin (in its current form) will survive, but I feel quite sure that it will survive in a form similar to the current one. Ie. a decentralized, peer-to-peer, fixed-supply digital currency.

So make a note in your 2032 calendar for the date Feb 11 with the link "https://financialcryptography.com/mt/archives/001324.html" to remind yourself! :)